Over the past 25 years of my radio show On-The-Money I have stressed the importance of proper investor behavior over actual investment performance. Year after year, studies reach the same conclusion; investors fall short of the returns of their own investments due to bad behavior.
Research firms have studied this issue by comparing mutual funds stated “time weighted” returns, vs. the “dollar weighted” returns of those funds. Time weighted return is the return an investor would have received if he or she began fully invested in the fund at the beginning of the period and remained so throughout the entire period. It is the standard way investment funds report their performance, so this is the return number you will see on a prospectus or marketing materials. Dollar weighted returns, on the other hand, consider in their calculation the cash flows in and out of a fund throughout the period and their compounding effect over time. Dollar weighted returns serve as a better approximation of what investors in that fund actually earned and are even commonly referred to as “investor returns.”
When Morningstar Magazine compared these two numbers for a wide variety of mutual funds in a recent article, they again confirmed what studies have shown to be true for decades: investors somehow managed to underperform their own investments!
Over the entire mutual fund group, they found that investors in the “All Funds” category underperformed the funds they owned by 0.53% per-year. US diversified fund investors lagged their own fund returns by 0.74% per-year. Investors in international funds seemed to behave even more badly, lagging the returns of their own funds by 1.24% per year.
The two areas that caught me by surprise were the Taxable Bond funds and the Municipal bond funds. Investors in those funds underperformed the funds they owned by 0.82% per year and 1.32% per-year respectively. Bad behavior clearly does not discriminate between asset classes.
It also does not discriminate based on skill level of the investor. When pension fund returns are studied, it is clear that even professional fund managers behave in a similar fashion.
What is the lesson of all of the data highlighting the behavior of investors? That is that investors, even professional investors, are not very good at timing when to buy and sell their own investments. This could be for any number of reasons, but the obvious culprit is that most investors can’t help but act on emotions swayed by recent performance. People get euphoric at market peaks and buy at terrible times; they panic at market bottoms and sell at terrible times. All of this bad behavior costs them dearly.
The antidote to all of this is to set an investment policy that defines an asset allocation that is appropriate to fund your goals, then simply rebalance the portfolio back to this asset allocation as necessary. The Morningstar study seems to confirm this, as investors in funds that target a certain asset allocation underperformed their investments by the smallest amount of any other group of funds.
But even a set allocation isn’t a guarantee against bad behavior as it doesn’t address the emotions that cause an investor to react with bad behavior. A bear market, defined as a decline of 20% or more in the stock market, occurs every 5 years or so on average. If you are a person that will get emotional and abandon a perfectly good investment plan because your portfolio is down, you may need the help of an advisor to “keep you in your seat” during these emotionally trying times.
The numbers in this article don’t even come close to capturing how much value an advisor can create for their clients by saving them from their own bad behavior. Using a typical bear market as an example, if an advisor can keep you from panic selling when your portfolio is down 20%, the type of mistake that permanently impacts your lifestyle, he or she just earned multiples of the fees you pay for his or her advice. Considering these type of declines occur every 5 years or so, the value an advisor can create by helping clients avoid bad behavior cannot be overstated.
Want to hear more about this topic? Below is a sound clip from our most recent radio show that includes a discussion between Paul Ruedi, David Ruedi CFP®, and Dr. Fred Giertz about this research and what investors can do to avoid their own bad behavior.